Will the Commodity Boom Bust Soon?

♠ Posted by Emmanuel in ,, at 12/19/2007 01:58:00 AM
I'm of two minds about this particular question concerning whether high commodity prices are here to stay or if they'll soon be a thing of the past. True, there have been many previous periods when commodity prices were elevated and many pundits spoke of permanently higher commodity prices. Yet, these prices came down eventually, and the same may happen again. In a nutshell, the yea and nay arguments go something like this:

(1) Yes, high commodity prices are here to stay. We are reaching Malthusian limits to resource supplies that weren't approached in the past. These constraints are fast approaching because the two largest countries in the world with a combined population of 2.3 billion persons, China and India, are now quickly moving up the income and, consequently, the consumption ladder. With so many people clamoring for a higher standard of living, there is a "demand pull" effect as folks fight over the same finite resources.

(2) No, each time commodity prices have been elevated in the past they've always gone down eventually. Currently, we are at the peak of a cycle led by US consumer demand. As the US economy slows down because overstretched American consumers can no longer drive global demand, things will cascade down the supply chain. Manufacturers will have less need for the commodities necessary in producing exports to America. This will eventually result in lowered commodity prices. Besides, technology and preferences have a way of changing patterns of demand in the long run so a plateau of higher commodity prices is far from given.

Which version do you find more realistic? I actually lean more towards (1)--2.3B people need to be fed, clothed, housed, cooled, heated, entertained, transported, etc. to a higher standard as industrialization takes place in China and India. For a take that is more like (2), however, the Daily Telegraph has one that is worth contemplating. Note that I am not a "peak oil" believer. There are ample supplies, but there are also serious political-economic impediments to accessing these supplies in totalitarian regimes. More often than not. multinationals which possess the expertise to extract these supplies more efficiently are being given the cold shoulder (viva la revolucion Bolivariana!):

Peak oil, peak metals, and this year peak food. Every bookshop has a corner warning that mankind will soon outrun the basic resources of the globe.

It was ever thus. Variants of the theme emerge at the top of each commodity super-cycle, only to be deferred for another 20 years or so as new supply comes on-stream and technology outwits the pessimists. Shortage can turn to glut very fast once inflation forces central banks to hit the brakes. Some will remember Limits to Growth, published by the Club of Rome in the 1970s. It said the world's oil reserves would run dry in 30 years. Gold supply would last nine years. The report spoke of the "sudden and uncontrollable collapse" of economic life. What in fact collapsed were oil and gold prices. We can see now that the 1970s was a central bank monetary bubble.

The question for investors who have sunk $150bn into commodity index funds - and trillions in mining and energy stocks - is whether the roaring boom of the last five years is another bubble, or whether the Malthusians are closer to the mark this time. Has the Asian renaissance - the "Great Doubling" of the world's consumer base - changed the balance for ever? The jury is out.

Charles Dumas, global strategist for Lombard Street Research, says the bulls are deluding themselves. "The long-run real return on commodities is negative, except for oil where it has been nil for one and a half centuries. "Smart investors have made huge profits at various times trading commodities. The price cycles can be violent. But it is a tough, cyclical game, fraught with risk. Portfolio positions can't just be comfortably locked away," he said.

Base metals are creatures of the industrial cycle. The US is already in the grip of the worst housing crash since the Slump. It is exporting a manufacturing crunch to Europe through the dollar slide and the banking crisis. Japan is slipping into recession, says Morgan Stanley. No surprise that copper is down 23 per cent since early October after quadrupling in five years. Lead is off 42 per cent. Nickel has dropped 53 per cent since May.

What is striking is that long-term futures contracts continue to set all-time highs, a sharp break with earlier patterns. "The message is simple: markets are looking past the short-term," said Barclays Capital. Oil refuses to buckle at all. Brent crude is hovering near $93 a barrel despite a shock report by the US intelligence concluding that Iran halted nuclear weapons work in 2003. It has left White House hawks beakless. The alleged war premium on oil has vanished, yet prices have barely flinched. "Will oil get to $100 a barrel? Yes, it's a done deal," says Paul Horsnell, commodities chief at Barclays Capital. Goldman Sachs have raised their forecast to $105 by the end of 2008, citing a chronic lack on investment. Who would want to invest in Russia, Venezuela, Ecuador or the "Stans" if expropriation were on the menu?

Oil output has been flat for two years, with the non-Opec trio of Britain, Norway, and Mexico in relentless decline. "Even at this price the oil companies still can't find any supply, which tells you that they are catching a serious crab," says Horsnell. "Oil has been going up a dollar a month for four years. It's a gradual upping of the pressure and I don't see anything to stop it," he says. The peak oil theory claims that the world is depleting crude at 30bn barrels each year, but adding just 10bn in discoveries. Depletion is running at 4 per cent a year (official) or 6 per cent (peakists). "A supply-side crunch in the period to 2015, involving an abrupt escalation in oil prices, cannot be ruled out," said the International Energy Agency in its Outlook report.

China's annual demand is growing at 0.4m barrels per day (bpd). It may reach 8m next year, or 9 per cent of world output. Global needs are expected to rise 50 per cent to 130m barrels by 2030, yet the heads of both Total and Conoco doubt whether output will ever reach 100m barrels before tipping over in 12 years or so. "Peak oil is the secret that everybody knows in the oil industry but has refused to talk about until now," says Chris Skrebowski, editor of Petroleum Review.

"If you look at all the big projects out there, oil output will peak in three years before gently declining thereafter. If there is any slippage, we may have reached the peak already," he says. The counter view is that there are vast reserves of oil sand or shale in Canada, Colorado, and Venezuela worth extracting at $60 prices and above. BP says it has used 3D seismic imaging and other tricks to raise extraction from its Prudhoe Bay field in Alaska from 40pc to 60pc of reserves. If replicated across the world's reserve base, it could add 1.4 trillion barrels, or 45 years' global supply at current demand.

Big if. For now, soaring prices are spilling over into food. Grains stocks are at their lowest in 60 years. Wheat prices have risen by 145 per cent since April. The culprits are biofuel crops, expected to take 12 per cent of global arable cropland within 12 years, according to Credit Suisse. The UN says the amount of ethanol - or "dethanol" to critics - needed to fill a medium car tank can feed a child for a year. Those driving Chelsea Tractors or over-powered BMWs are directly causing hunger - or worse - in poor food-importing countries. The UN food rapporteur Jean Ziegler has called for a five-year ban on ethanol. "It's a total disaster for those who are starving," he says.

The big unknown for commodities in 2008 is whether the supply crunch will eclipse a likely US recession and all its knock-on effects. Rate cuts in the US have caused a fresh surge of liquidity in East Asia and the Mid-East, flooding those countries with dollar pegs or semi-pegs - led by China. Inflation has reached 6.9pc in China, 9.5pc in Vietnam, and risks spiralling out of control in the Gulf. All will have to ration credit or break their pegs. Either way, the game is nearly up.

Once the emerging market boil is lanced we will find out where the core equilibrium price for oil, coal, iron, zinc, and soya beans really lies. Then we can strap up for the second leg super-cycle. Next time to the peaks.